Real effective exchange rate of RMB in decline

09:24, July 24, 2011

The State Administration of Foreign Exchange released the "Question and Answers on Foreign Exchange Reserves" on July 20 and reaffirmed that the appreciation of the RMB will not directly cause losses in foreign exchange reserves. How does the RMB exchange rate influence China's export trades and overseas investment? Reporters interviewed related parties regarding this question.

Real effective exchange rate fell more than 3 percent in first half

The middle rate of the RMB against the U.S. dollar has increased more than 5 percent since the further reforms of the mechanism for setting the RMB exchange rate in June 2010.

Although the middle rate of RMB against the U.S. dollar continues to increase in 2011, the real effective exchange rate of the RMB showed a decline in the first half of 2011, exceeding the appreciation on the whole. The middle rate of the RMB against the U.S. dollar increased by more than 2 percent in the first half of 2011, and the real effective exchange rate of RMB showed a depreciation trend in January, March, April and June, while it appreciated in February and May. The real effective exchange rate fell more than 3 percent in the first half of 2011.

Data recently released by the Bank for International Settlement shows that the real efficient exchange rate index of RMB stood at more than 116.3 in June, a decline of nearly 2 percent compared with May, and the nominal effective exchange rate index of the RMB stood at nearly 112.1, a decline of nearly 2 percent compared with May.

Ding Zhijie, president of the School of Banking and Finance under the University of International Business and Economics, said that many people observed that although the exchange rate of the RMB against the U.S. dollar increased, the exchange rate of the RMB against many other currencies shows overall depreciation. Therefore, it is not true that the appreciation of the RMB has accelerated since the reform.

Reason why RMB showed overall depreciation

Why has the RMB appreciated against the U.S. dollar while its overall real effective exchange rate depreciated?

Zhang Yansheng, director of the Institute of Foreign Trade under the National Development and Reform Commission, said that the U.S. dollar is on a "long-term depreciation path" due to the United States' low interest rates, quantitative easing policy and high unemployment rate. Furthermore, the recent battle between Democrats and Republicans over raising the U.S. debt ceiling has added uncertainty to the future of the country’s economy and caused the dollar to drop sharply against most major currencies. The yuan has risen against the U.S. dollar but fallen against other major currencies because the appreciation of the yuan could not completely offset the depreciation of the dollar.

"China should further the reform of the RMB exchange rate regime and peg the yuan to a basket of currencies rather than just to the U.S. dollar, though it takes some time to make adjustments based on the real effective exchange rate of the RMB. In the past six months, the yuan has risen against the dollar relatively quickly, but its real effective exchange rate has fallen," Zhang said.

Xie Taifeng, dean of the School of Finance under the Capital University of Economics and Business, said that the real exchange rate is the weighted average of a country's currency adjusted for the effects of inflation. The nominal exchange rate of the RMB has been increasing, but its real value has dropped sharply due to high inflation since the beginning of 2011. Both the euro zone and dollar bloc are predicting inflation of around 2 percent in 2011, while China's inflation target for the year is much higher than 2 percent.

"Consumer prices are closely related to the exchange rate between two countries' currencies. The real exchange rate is adjusted for inflation, and the real value of the yuan has dropped quickly, so there is really no reason for yuan appreciation," Xie said.

"Double-edge sword effect" requires attention

However, in the context of a possible economic slowdown in economic growth, the quite strong expectation of RMB appreciation and the exchange rate that are attracting hot money will hit China's export-orientated enterprises on the one hand but will benefit the overseas investments of China's enterprises on the other hand. Therefore, China should always pay close attention to the "double-edge sword effect" of the exchange rate.

"Globally, the production system of the U.S. dollar is much larger than that of euro or any other currency. Therefore, whether China will carry out the 'bringing in' strategy or accelerate its 'going out' strategy, the future trend of the U.S. dollar exchange rate will inevitably affect the expected incomes or cash flows of costs of China's overseas investments," Zhang said.

Zhang said if the RMB appreciates to a great degree against the U.S. dollar, it means a certain amount of RMB could be changed for more U.S. dollars. In that case, China will benefit if it invests in U.S. dollar regions or regions where prices are marked by U.S. dollar but will suffer if it invests in non-U.S. dollar regions.

"In addition, great RMB appreciation will increase the costs of foreign merchants' investments in China, raise the prices of RMB assets and slow down the growth of long-term investments. But meanwhile, it will also generate more opportunities for international capital to obtain short-term profits in China and aggravate the fluctuation of China's macro-economy."

"RMB appreciation against the U.S. dollar will deviate from the actual purchasing power of the currencies of the two counties. At the current exchange rate, since there is little risk involved in purchasing RMB, many venture capitalists will certainly be attracted. Meanwhile, the public's willingness to hold foreign currencies has become very weak, but foreign currencies have a strong desire to get RMB loans, because they, with the expectation of RMB appreciation, will benefit while repaying the loans in the future. On the one hand, the RMB is depreciating within China; on the other hand, the foreign exchange reserve and the surplus are increasing. These abnormal phenomena are both caused by the RMB appreciation against U.S. dollar," Xie said.

In addition, the RMB appreciation will also bring a lot of difficulties to the export-orientated enterprises. The bankrupt toy manufacturing enterprises in the city of Dongguan are just examples. These enterprises, which have created a lot of jobs, not only have difficulties finding financing within China but also are under the pressure of RMB appreciation. Therefore, the RMB appreciation makes against the export-orientated, labor-intensive enterprises.